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2012 provides an unprecedented opportunity (a perfect storm, in a good sense) to transfer wealth to future generations gift and estate tax free.

The federal estate tax is only vulnerable to lifetime gifts and or testamentary transfers to charity. Thus, in order to transfer wealth free of estate tax taxes to family members, high-net-worth individuals must make lifetime gifts. For the reasons discussed below, 2012 provides an unprecedented opportunity (a perfect storm, in a good sense) to transfer wealth to future generations gift and estate tax free.

Bush tax cuts expiring

The Tax Relief Act of 2010 increased the 2012 gift tax exemption to $5.12 million per person and lowered the top gift tax rate to 35 percent. However, on January 1, 2013, the estate and gift tax exemptions are scheduled to return to $1 million and the top gift and estate tax rates are scheduled to increase to 55 percent.

Most Republicans (including Governor Romney) favor repealing the estate tax. On the other side of the aisle, for the president's 2013 budget, he has proposed a $3.5 million estate tax exemption, a $1 million gift tax exemption and a top tax rate of 45 percent.

Obviously, the fate of the gift and estate tax exemptions will rest with the election results, but anyone who dies after 2012 has no assurance he/she will be permitted to transfer $5.12 million tax free at death. Therefore, high-net-worth individuals are well advised to use their gift tax exemption in 2012 while it is still available.

Historically low interest rates

Loans — Because of historically low interest rates, 2012 presents a unique opportunity for donors to transfer wealth to children and more remote descendants. The simplest technique is to lend money (or sell assets on installments) to a grantor trust for the benefit of family members in exchange for a promissory note. For estate tax reasons, the grantor should first gift to the trust 10 percent of the amount of the loan.

The promissory note would bear interest at the Applicable Federal Rate (for July 2012, 0.24 percent for loans of three years or less [the short term rate]; 0.92 percent for loans of more than three years, but not more than nine years [the mid-term rate]; and 2.3 percent for loans of more than nine years [the long term rate]). The interest on the note is payable annually with a balloon payment due at the end of the term. If the trust earns a greater return than the interest rate on the note (i.e., the hurdle rate), then the excess income and appreciation is removed from the grantor’s estate — gift tax free. Additional wealth is transferred (gift tax free) by the grantor’s payment of the trust’s income taxes. For those persons who have already made loans to family members, now may be the time to refinance those loans to take advantage of the lower interest rates.
SCINs — Two variations of a promissory note transaction are a self-cancelling installment note (SCIN) and a private annuity. In the typical SCIN transaction, the seller/lender is the parent and a trust for the benefit of children is the buyer/borrower. If the parent dies prior to the end of the note term, no further payments are due. While the cancellation feature must be paid for (usually by an increased interest rate on the note), substantial estate tax savings are possible because the balance due on the note at the seller’s death is not included in the seller’s estate.

Private annuities — In the typical private annuity transaction, a parent transfers property to a child in return for the child’s unsecured promise to make a fixed, periodic payment to the parent for life. If the fair market value of the property transferred equals the present value of the annuity (actuarially determined using the IRC Section 7520 rate), there is no gift tax due. Similar to the SCIN, a private annuity produces a benefit when the parent dies prior to his or her life expectancy, and a disadvantage if the parent outlives his or her life expectancy. Both the SCIN and private annuity are even more beneficial when interest rates are low.

GRATs — A grantor retained annuity trust (GRAT) is another way to transfer wealth utilizing the current low interest rates. GRATs allow for the transfer of assets to family members at a nominal gift tax value. The grantor transfers assets to an irrevocable trust that pays the grantor a fixed annuity for a set term of years. The annuity is designed to return to the grantor the entire amount of the gift plus interest. The interest for a GRAT is the IRC Section 7520 rate which is 120 percent of the mid-term AFR (1.2 percent for July, 2012). To the extent the assets in the GRAT appreciate more than 1.2 percent (the hurdle rate), the assets remaining in the GRAT at the end of the term pass to the remaindermen (usually the grantor’s children or a trust for their benefit) free of transfer taxes.

CLATs — Lastly, a charitable lead annuity trust (CLAT) is a method for charitably-minded donors to transfer assets to both charity and to family members in a tax efficient manner. A CLAT is an irrevocable trust that pays one or more charities a fixed annuity for a set term of years. In return, the grantor receives a gift tax charitable deduction. At the end of the term, any assets remaining in the CLAT pass to the remainder non-charitable beneficiaries (usually the grantor’s children).

Similar to the annuity payable to the grantor in a GRAT, the charitable annuity in a CLAT can be set for an amount and term that results in a nominal gift. To the extent the assets in the CLAT grow at a rate in excess of the Section 7520 rate, the grantor has made tax-free gifts to his or her beneficiaries (or trust for their benefit). Again, low interest rates make CLATs an even more effective wealth transfer strategy.
Relatively low asset values

The value of real estate and securities are at low levels, making it more attractive to gift such assets to children and grandchildren. In addition, economic turmoil has created tremendous volatility and lots of fiscal challenges for business owners, making now the ideal time to gift business interests. Transferring assets when values are low relative to other times and circumstances can save substantial gift and estate tax dollars for families. This is especially true if values rebound or increase significantly following the transfer.

President Obama’s budget proposals

As mentioned above, President Obama’s proposed budget for 2013 (issued on February 13, 2012) would permanently restore the estate tax system that was in effect in 2009 — a $3.5 million exemption with a top tax rate of 45 percent. Perhaps more importantly, the gift tax and GST exemption would be reduced to $1 million, bringing an end to the unification of the gift and estate tax exemptions. Other proposals include:

Grantor trusts — In a major rewrite of the estate tax provisions, any individual who is taxed as the owner of a trust for income tax purposes will have to include the trust assets in his or her gross estate for federal estate tax purposes. And distributions from such grantor trusts to beneficiaries during the grantor’s lifetime would be subject to gift tax. These rules would apply to trusts created on or after the enactment date and to any contributions made after the enactment date to grandfathered trusts.

Although the proposal appears to be targeting installment sales to intentionally defective grantor trusts, the implications are far greater. For example, most irrevocable life insurance trusts (ILITs) are grantor trusts under IRC Section 677(a)(3) (because trust income can be used to pay premiums on a policy insuring the life of the grantor or the grantor's spouse); or under IRC Section 677(a)(1) and (2) (because trust income may be distributed to the grantor's spouse without the consent of an adverse party). Thus, if enacted, the proposal could result in the proceeds in an ILIT being subject to estate taxes.

Dynasty Trusts — Dynasty trusts are also under attack. Under the president's proposal, the generation-skipping tax exemption would be limited to 90 years. Thus, distributions from trusts established in states that allow trusts to continue in perpetuity (like Michigan) or for a very long time (like 360 years in Florida) would be subject to generation-skipping taxes after 90 years. Trusts created before the enactment date of this proposal would be grandfathered.
Short-term GRATs — Two-year, zeroed-out, grantor-retained annuity trusts have become one of the most popular wealth transfer planning techniques in recent years due to the low Section 7520 hurdle rate (1.2 percent for July 2012). The president's proposal would do away with the technique by requiring a GRAT to have a minimum term of 10 years, greatly accentuating the mortality risk of using a GRAT.

Valuation discounts — Valuation discounts obtained through the use of family limited partnerships and family limited liability companies allow donors to "leverage" their $13,000 annual gift tax exclusion and $5.12 million gift tax exemption. Although lacking in details, the president's proposal would scale back the use of such discounts retroactively to October 8, 1990 (the effective date of IRC Section 2704). These proposed changes add further urgency for high-net-worth individuals to make discounted gifts in 2012.

Conclusion

The confluence of an historically high (though temporary) estate and gift tax exemption, historically low interest rates and economic events depressing asset values has created a rare opportunity for proactive estate planning and represents a major window of opportunity for high-net-worth individuals to avoid estate taxes. In short, 2012 presents the greatest opportunity for wealth transfer planning to date.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.

About the Author

Julius H. Giarmarco, Esq. is a partner and heads up the firm's Trusts and Estates Practice Group. Julius received his law degree (J.D.) from Wayne State University, and his master of laws (LL.M.) from New York University. His primary practice areas include estate planning, business succession pla... More